European Energy Woes

Euro-Russian relations have strained over the recent years in energy matters as certain vested interests shifted perceptions into the realm of what I would express as logical fallacies – technically making sense to a degree, but only when numerous caveats are applied. In this post issues like energy weaponry (enormous logical fallacy in my opinion), market reforms, looming contract litigation, energy security, shale revolution and domestic challenges will be discussed. In this post I am joined by the Head of Oil and Gas at the Energy Research Institute of the Russian Academy of Sciences, Dr. Tatiana Mitrova. This is the first of two posts from this special series, so keep tuned, please feel free to comment and enjoy!

Personal Note:

My regular readers may have noticed that I have recently been away from blogging, Twitter and journalism; this is because I was finishing my M.A. Double-International Award in World Politics and World Economics. As it turned out, this intermission was sensible as I ended my studies with the highest grade of Distinction. As I am finished with my studies and no longer have to worry about plagiarism, I hope to share some of the findings and research conducted. In this first post of two-part special, a Europe-Russia focused question and answer session is outlined with Dr. Tatiana Mitrova, whereas in the subsequent second post, coming later, we look at China-Russia. 

Europe-Russia ‘Special Deal Severed’:

In normal day-to-day life Europe has a stable and diversified supply structure. It is currently doing enough to diversify its supplies so it does not undermine its energy security, but for a region which will dependent on imports for 80% (some sources even indicate 88-90%) of its energy needs by 2025-2030, it will naturally be more susceptible to risks. Any setbacks, or sudden events, ala Fukushima or Arab Spring will have serious repercussions. If something happens, Europeans will not be able to sustain themselves via own reserves or domestic production, due to this heavy import dependence. In reality, we are talking about a market which is several times bigger than Japan or alike, so it is difficult to fulfil demand in unforeseen events.

The deal between Europe and USSR was very interesting in nature, as if anything went horribly wrong, the Soviet would support the region with its exports. It was an unwritten deal, with extra capacity always available from the Soviets in case of any problems in Europe. Today, Europe is categorically rejecting this ‘special deal’ with Russia. So if anything happens, like North Africa stops production or the Hormuz Strait is closed (all possible events), then Russia will still supply Europe as excess pipeline capacity and profit factor exists, but it will charge exuberant price rates. So Europe’s actions have created a possible financial risk for the region, as these special relations have been severed, so now any future relations will be priced on the basis of a deficit market. The question remains open, is the trade-off worth it?

Energy Weaponry Myth:

Pathological fear does exist, that Gazprom may in some way use its power to influence Europe as a dominant supplier. However, in reality, if we look retrospectively there are no real precedents to Gazprom applying its power, there were some threats issued, but not real actions. Also, it is important to look at countries primary energy consumption, as in fact most are not as dependent as media or others tend to suggest. Gas tends to make up a small portion of the total energy mix in most countries, even in those typically outlined as overly dependent. As we have seen USSR never applied its energy in a weaponry type way, so there is no reason why Russia would do this now. 

Long-Term to Short-Term Contracts - Technical & Commercial Caveats:

This change will require a different dispatch system. In fact the balancing of a mixture of contracts already requires a new level of competence and in turn more investment which previously was not required. As we know, more investment means more cost and greater end-consumer price. For Russia, this is especially a major issue as all the loans for developing new fields and constructing new pipes are done via long-term contracts. This is vital for Gazprom, as the lending banks absolutely adore long-term contracts, especially if they are linked to oil. For instance, the Nord Stream project had a queue of 27 banks. For banks these deals are especially attractive now, as for them to receive guaranteed profit in the middle of a recession for the next 25 years – is amazing. Without long-term contracts, Gazprom will find fundraising a lot more difficult and the sums of money needed is huge.

EU may Axe Algerian & Russian Long-Term Contracts:

No one knows for sure, but contracts can only be ended by a legal decision or arbitrage court. There are no precedents in continental Europe, but there were precedents in USA and Great Britain – however these are of Anglo-Saxon model so the positions are different in comparison to the EU. Situation there ended in a cancellation of the long-term contracts, but compensation was paid out to the suppliers – contracts were torn with Libya, Algeria and LNG supplies between USA and GB, involving British Gas. However, most contracts were ended on mutual consent – which was done essentially due to pressure.

It is difficult to say whether this is possible in mainland Europe, as back then USA and GB were self-sufficient in energy so these contracts were not vital. However in Europe, we are talking about a region that will be increasing its energy imports. So would it be rational, for say arbitrage court in Stockholm to terminate a contract with a major supplier, as they would realise that any future contracts will be much more difficult to secure? This action would seriously undermine EU’s energy security, which by the year 2030 will be 80% dependent on gas imports. This would be a huge mistake for EU and highly risky, however euro-bureaucrats can technically do this, but hopefully they will not as otherwise any talk of or hopes for interdependence or liberal cooperation will simply collapse once and for all.

'Gas-OPEC' Unlikely, Yet:

Theoretically this remains a possibility. However, this will likely to be a concealed agreement between suppliers (not like OPEC). So technically no one will sit down to discuss the official cartel, but in reality it will be  present as everyone will play the same game, towards the same direction. Even as we move to hub-trading, it will not dismiss supplier manipulation; for instance, output increase by Qatar causes a fall in prices, whereas rise in maintenance costs in Netherlands results in a price increase at the NBP (National Balancing Point Hub UK), these changes can be foreseen and manipulated quite easily. Also, as the NBP (key mechanism to deciding EU's hub prices) does not trade large volumes yet, it makes it more possible. It is hard for exporters to disregard this yearning to manipulate prices and it will happen. Still, it is currently quite difficult to draw conclusions on whether an official united tactic will emerge, as Gazprom is categorically against moving to the spot-markets and it will maintain this stance for the next 3-4 years. Basically, Gazprom will keep supplying minimal amounts of gas via spot-prices and defend its position, which means without this player we cannot see Gas-OPEC materialising. Also, will Qatar agree to lift their moratorium and will Algeria continue to increase its production – like Gazprom they will continue to push for oil-pegged prices – as their government's revenues come from these spheres. Thus, there are many uncertainties, so we ought to come back to this question closer to 2016-2017. 

Gazprom Will Not Budge: 

Gazprom will not lower prices to remain competitive, it will continue defending its oil-indexed position for a collection of reasons. It will not lower prices to increase export volumes as things stand. This position will be maintained for the next 3-4 years. Gazprom adheres to the following practice in Europe: if it is taken to the arbitrage court it always negotiates and lowers prices or at least its behaviour has been like this up to now. This is a delay tactic as it does not want to end up in damaging litigation nor public scandal, but at the same time it does not want to lose ground by simply accepting others terms. A court battle is the last thing Gazprom would want. 

EU Importers are Commercially Motivated:

Importers see energy trade from a clear commercial interest as the difference of $100 per 1000 cubic meters, between spot-prices and oil-pegged contracts is too great. This price disparity pushes companies like E.ON or RWE AG onto the edge of bankruptcy. As these companies have to sell their products at spot-prices (due to the EU rules), they are effectively subsidising the difference out of their own pocket. Their financial balances are currently taking substantial pressure and it is clearly visible. It is an unacceptable condition and they cannot sustain like this for long. This is why there are a lot of heated discussions with Gazprom, as otherwise they have to compensate the difference with their own funds. Of course, we can recall those days when Gazprom prices were substantially lower than elsewhere and these firms were selling gas for large profit margins – this is something Gazprom does not fail to underline during discussions as this is true. However, past profits no longer remedy the situation today as they need to survive, no matter the means. 

Anti-Gas EU is Now a 'Hybrid Market':

No exact figures exist, but about 40-45% of gas is already supplied by the spot indexes, directly or even indirectly. Hence, we already almost have a hybrid system as the spot market nearly equals oil-pegged prices. Also, there is an evident tendency towards shorter contracts, especially Russian ones, as before contracts were between 25-30 years, but today they tend to be between 10-15. The major issue is that the EU has no 'road-map', so many of the goals are not outlined and behaviour is impulsive, which is not conducive to business. By just looking at the figures, the European Union is evidently 'anti-gas' as customers are clearly feeling that they do not need to contract for up to 30 years. In essence, contract's length will continue to fall, whilst the proportion of spot trading will continue to increase, as Europeans have psychologically turned to the spot-pricing system. They understand all the risks, they understand that spot-prices will not always be cheaper than oil-linked prices, but they have one argument – which is common today – ‘I do not care what price I pay and I do not care how it is calculated, but that price should not be more than my competitor’. If my competitor is buying on the spot market, I need to buy on the spot market, as I cannot allow for this divergence.

Price Equalization is Unrealistic across Unequal Europe:

If we look at the price of Coca-Cola across the world and then compare it, it becomes obvious that prices are incredibly diverse, yet a more harmonized product cannot be imagined. No one seems to mention about price discrimination of Coca-Cola, it’s a simple principle, if you do not like it, then do not buy it. In truth, the energy market prices represent so many components that it is even difficult to explain it by economic and political factors. However, at the current stage under the conditions of non-liquid, non-transparent and non-competitive European market, to suggest that we should follow a basic principle of free market as found in an economic textbook, is unrealistic at best, as it requires a perfect market. We do not yet have these conditions.

No special order can be successful in launching this idea, but some harmonization has occurred. As we’ve seen with Ukraine, it has a liberal economy and it has been able to use reverse flows to buy gas cheaper than from Gazprom, by not very much, but still cheaper. So, sooner or later, Gazprom will need to drop prices. As European market will develop, we may see many companies emerge that will be able to shift gas via many different routes. Simply having the same price across the board is absurd or trying to push some revolutionary policies that do not reflect market peculiarities. The market must be given time to evolve naturally.

Giant-Shtokman Gas Field - Will be Idle:

As Europe is proving to be a difficult market for Russia due to price liberalization, long-term contracts decline and oil-pegged prices rejection, the Shtokman field was postponed and its development was rejected, perhaps, for the next 10 years. Also, as the US market is quickly becoming self-sustainable due to the Shale Revolution, the Shtokman gas can no longer be sold in that direction. Although this field hold massive reserves enough to sustain Europe, it requires extensive investment due to harsh environmental conditions and its distant location. 

Innovation is a Question of Survival for Russia:

The ongoing discussions in Russia are not so much about developing innovation, but about applying international best practices. That is why companies like Schlumberger are active in Russia. For Russia, their technology is relatively new due to our industry backwardness. In essence, Russia is currently a 'game-follower', rather than 'game-changer'. In even harsher terms, innovation for Russia is a question of survival and of remaining competitive. Right now, ever increasing costs are quickly pushing Russia into the category of 'non-viable' supplier for Europe, or put simply the most expensive one on the market; for instance the current tax regime is really imploding our competitiveness and price levels.

Moreover, everything is great in regards to the USSR fields as everything there is developed for export, but practically all of Russia's new projects are too expensive; in certain areas the most expensive in the world. As a result, in perhaps 10 years, Russian oil and our gas will be amid the most expensive on the market. Hence, any fluctuations on the market will have a direct effect on the economy as returns will be forgone. So the question of innovation is no longer about aesthetic aspects of being the most appealing, but about the ability to just being able to compete.

Internal Scuffles & Uncertainty - Russia's Domestic Gas Prices:

In early 2013 there were talks about possible price increases in Russia (possibly of about 15% in 2015), it is likely that next year (2014) we will see the most stringent debate over the issue. As of right now we have a difficult situation within the internal market as there is a sizeable over-supply with rooted demand whilst at the same time competition between three giants is increasing: Gazprom, Novatek and Rosneft. Novatek and Rosneft are already selling gas at discounted prices of 5-10% in contrast to the Russian Federal Tariff Service (FST) which Gazprom follows, so it means they are working within a profit margin and the existing price level is market orientated. Hence, the rational question arises why do we need to raise this price? As we see, major consumers like electricity generators are unhappy about price rises and they are protesting against this possibility. If the gas stock market is instigated by the end of this year or the beginning of the next year (it is already delayed as it was set to launch in spring of 2013), we would see an even clearer price differential between FST which underpins Gazprom and the legally freer Rosneft and Novatek. We are currently seeing internal scuffles between Minenergo (Russian Ministry of Energy), Mineconom (Ministry of Economic Development of the RF), Gazprom and others, on how to proceed, but as of yet no clear vision exists and we are yet to begin discussing this topic seriously.

US Shale Gas Export - The Psychological Revolution:

US shale gas export is highly contentious: Sabine Pass LNG was granted non-FTA (Non-Free Trade Agreement Countries) export status, then it was actually frozen, but not withdrawn. Then, we have seen deals involving South Korea alongside others and just recently developments occurred insofar as Freeport LNG export. Hence, we will see export materialising and within the scope of the industry, it will be relatively quick (even several years is quick for gas). However, the question is how many projects will receive permission? We are likely to see a sizeable figure of 50-60bcm till 2020 per year, unlikely more, as we can expect that ~30% of applications will succeed, but the future of these will be evaluated on individual stringent basis. This could potentially be unpleasant for Russian exports, particularly in places like Asia where competition is already heated, but in reality this competition is likely to be more indirect, especially in Europe as LNG that was originally aimed at US will possibly end up there.

Before the shale revolution European spot prices were higher than Russian pipeline gas, but this game changing event resulted in a collapse of spot prices as relatively suddenly an excess of 40 bcm of LNG appeared. As a result this pushed for a change of pricing mechanisms in Europe, alongside the reasons of recession and bankruptcies, which all in turn undermined Gazprom. An analogues situation is starting to occur in Asia, with certain contracts already signed with pegs to the Henry Hub prices. Many Asian countries are struggling under excessive prices (~$14-16 per MBTU) and see the shale revolution as a great panacea. For them, a reason for undermining the old mechanism of oil-pegged prices was finally found. Obviously, we must keep in mind that USA's suppliers are all different, for instance not everyone will be able to supply as Sabine Pass – which invested heavily into innovation – others will find it difficult to match such low prices. In effect, there is a psychological shift, as potentially there could be imports from US and potentially it could be bought via spot-prices of Henry Hub. This could undermine Russia and even Canada which recently said it was unhappy with such artificially low prices, due to restricted export, as they were way below its own break-even production price.

'Gasland' Documentary's Infamous 'Halliburton Loophole' - Real?

This issue creeps up intermittingly and there is a lot of speculation around shale, both for and against it, but the proposition that the hand of Dick Cheney, who was at the time connected to the industry and even generated personal wealth from it, had intentionally changed legislation in the effort to improve his own and industry's position is difficult to prove. Theoretically one cannot deny this possibility, as in the modern world it will hardly be surprising, but neither can this be checked. One hopes that this would have led to a big scandal in the US during the election, so if it was in fact true one would expect that the Democrats would have highlighted this for political gain. The democratic institution of check & balances does exist in the US system when we talk about completely impudent major actions, so perhaps there is over exaggeration in regards to this matter. However, undoubtedly, the US environmental legislation is much more lax than the one in Europe, but this has always been the case, for one of the reasons being population density as USA is much bigger and less populated.

Special Thanks to Dr. Tatiana Mitrova for this Discussion.

Igor Ossipov

M.A. University of Kent & Higher School of Economics, Oil/Diesel Broker and RIAC Blogger.